Real options theory

Economic investment decisions, such as purchasing new equipment, increasing the work force or developing new products, as well as project economic valuation, are affected by economic uncertainty, technical uncertainty and by the managerial flexibilities embedded in the project. Economic uncertainty is caused by factors external to the project and is generally represented by stochastic oscillations in product prices and by costs. Technical uncertainty is caused by internal factors, such as uncertainty regarding the production size and the project's performance as a result of the technologies employed. The managerial flexibilities that are built into projects give managers the freedom to make decisions such as to invest, to expand, temporarily shut down or abandon a given project. Such flexibilities are called real options. If any one of these possibilities is ignored in the economic analysis, the project may perhaps be under-assessed and this may lead to irreversible decision-making errors. Therefore, managerial flexibility has a value which is not taken into account by conventional techniques such as the net present value (NPV) and the internal return rate (IRR) techniques. In addition to uncertainty, real options also consider managerial flexibility and their objective is to maximize the investment opportunity value.